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American authorities in Berlin said the two dead were an American soldier and a Turkish woman of 28.
The bomb went off at 0150 local time (2350 GMT) when La Belle disco was packed with nearly 500 people.
The disco is a favourite with American servicemen, and many of those injured were soldiers.
The outside walls of the building, which had been surrounded by scaffolding for rebuilding work, were blown in by the blast. The floor and ceiling also collapsed.
"There was suddenly a loud bang, unbelievably loud," said a disc-jockey. "Then I found myself in the cellar as the floor had collapsed."
Dieter Jaehner, 46, who lives nearby, said, "I saw through my balcony window men and women running in and out of the disco.
"They were waving their arms about and were in an hysterical state. Some were covered in blood, and their clothes were in tatters."
The explosion was the second in West Berlin in a week. Last Saturday, a bomb wrecked a German-Arab club in the city and injured seven Arabs.
The West German foreign minister, Hans-Dietrich Genscher, said a special group would be set up to investigate the possible involvement of a foreign country in the attack.
"We will not let our American friends be bombed out of our country," he said.
West Berlin police said they are considering the possibility that a Libyan terrorist group is behind the attack.
The 7,000 American servicemen stationed in West Berlin have been under high security alert since a US naval strike against Libya in the Gulf of Sirte last month.
US military installations have been under heavy guard, but there are no security measures for nightspots frequented by off-duty servicemen.
A caller to a London news agency said the bomb was the work of the Holger Meins Commando, linked to the Baader-Meinhof Red Army faction.
Another call to a Berlin news agency said a group called the Anti-American Arab Liberation Front was responsible.
The head of West Berlin's internal security office, however, said none of the claims could yet be considered authentic.
West German police have now reinforced controls at crossing points to East Berlin as an intensive search for the bombers continues.
A second US soldier died shortly after the blast, bringing the number of dead to three. More than 200 were found to have been injured.
Ten days later, the US government retaliated by bombing Libya. At least 60 people, including the adopted daughter of Libyan leader Muammar Gaddafi, died.
Libya's response was the bombing of a Pan-Am passenger jet over the Scottish town of Lockerbie in 1988, killing 270 people.
In 1996, three men and a woman were convicted of planning La Belle disco bombing.
The three men all worked for the Libyan embassy in East Berlin.
The woman, the German wife of one of the embassy workers, was convicted of murder after it was found she had planted the bomb.
In September 2004, in a series of moves aimed at ending Libya's pariah status, Colonel Gaddafi agreed to pay $35m to 150 non-US victims of the bomb.
However, Libya has said it will not pay for US victims until Washington pays compensation for the lives and property lost in the subsequent US air strikes on Libya.
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